The fiscal deficit was lowered by inflation - IDESA

Report Nº: 84530/01/2020

The fiscal deficit was lowered by inflation

The year 2019 shows a significant reduction in the primary fiscal deficit. However, this is the result of a costly and unsustainable process. It is based on the loss of real value on pensions, salaries and public investment produced by inflation. A comprehensive ordering of the public sector is needed to achieve a genuine fiscal […]

The previous government inherited a very precarious fiscal situation in 2015. The fiscal deficit was 5.1% of GDP and the national government was in default. The initial strategy avoided ordering the public sector because it was thought anti-popular. Instead, the decision was to rely on the new government’s high credibility in the business world to attract a “rain of investment” and boost growth. This would bring increases in tax revenues. Keeping public spending constant in terms of inflation –but decreasing in terms of GDP–, the fiscal deficit would disappear. Debt in dollars financed the transition to avoid inflationary monetary expansion.

The reality showed that investment and economic growth require more than declamations. Revenues grew less than expected and expenditures more than projected, since no significant changes were made in the organization of the public sector. The main consequence was an abusive use of public debt that resulted in exponential growth of interest payments and exchange rate overvaluation. When the economic crisis broke out in early 2018, the national government was forced to change its strategy.

Between 2017 and 2019, already in an emergency, primary fiscal expenditure was reduced by 4.1% of GDP. The main items that explain this adjustment are:

  • Approximately 47% is explained by the loss in the real value of pensions and public wages.
  • The reduction in the real value of public investment explains another 21%.
  • The reduction in the real value of public tariff subsidies explains another 14%.

These data show that the reduction in primary public spending was significant, but not sustainable. Almost half of the drop is explained by the loss of real value of pensions and public salaries caused by inflation. Another quarter of the reduction is explained by the slower growth of public investment relative to the increase in prices. In other words, almost three-quarters of the decrease in public spending was not due to changes in the public sector but to inflationary depreciation. The only important item where changes were made are subsidies to public services. The drop in expenditure is sustainable as long as the recovery of the real value of tariffs is maintained.

Thus, the devaluation not only created the conditions to restore the external trade balance but also the public finances. Devaluation accelerated inflation, which made the fiscal adjustment. It is not that the state spends less because it has reconsidered the organization of the pension system or because it corrected excessive bureaucracy and inefficiencies. On the contrary, the primary source of expenditure reduction was the temporary lag in the updating of pensions, salaries, and other state expenditures.

Reducing public spending in this manner is socially costly, economically inefficient, and unsustainable over time. Unless inflation accelerates, the tendency is to the recovering of the real value in pensions, public wages, and public investment. This is so because legal issues (for example, the pension rules and doctrine regulate pension indexation), and by pressure from state trade unions or the need to invest in infrastructure. Fiscal adjustment based on inflationary depreciation is typical of a crisis. Still, it cannot be sustained over time, much less to generate conditions for growth and social progress.

Therefore, the re-profiling of public debt is neither the most critical issue nor the most complex to solve. Assuming, for instance, that 100% of the debt is forgiven, the central problem would still be the public sector, which tends to spend, structurally, more than it collects. Hence, the decisive issue is to move forward with a profound tax, pension, and functional ordering of the state. Otherwise, devaluations and inflation will fatally adjust the public finances.


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